Comm'r of Internal Revenue

Tax Court of the United States.Jul 18, 1949
13 T.C. 95 (U.S.T.C. 1949)

Docket Nos. 15890 15891 15892.



Benjamin Leader, Esq., Alfred Swedlaw, Esq., and Eugene Gilmer, Esq., for the petitioners. Homer F. Benson, Esq., for the respondent

1. Petitioner, a general insurance agency, wrote insurance policies on a large number of properties owned or controlled by Farm Security Administration. Under petitioner's contract with the insuring company its commissions on policies covering more than one year were placed in escrow and released to it each year ratably over the life of the policies. Petitioner was required under the contract to service the policies over their full terms. Held, that the petitioner, reporting on an accrual basis, is taxable in each year on only that portion of the commissions which it became entitled to receive during the year.

2. Reasonable compensation for services rendered to petitioner by its two principal officers determined.

2. Reasonable compensation for services rendered to petitioner by its two principal officers determined.

3. The Commissioner's allocation, under section 45, Internal Revenue Code, of office expenses among the three taxpayer companies which occupied space in the same office building and shared certain office facilities sustained for lack of proof that it was arbitrary and unreasonable.

4. Loss resulting from restitution of funds collected by petitioner as real estate rental agent and embezzled by one or more of its employees, held, deductible in the year of such restitution. Benjamin Leader, Esq., Alfred Swedlaw, Esq., and Eugene Gilmer, Esq., for the petitioners. Homer F. Benson, Esq., for the respondent

These proceedings, consolidated for hearing, involve deficiencies in income, declared value excess profits, and excess profits taxes as follows:

+-------------------------------------------------------------+ ¦ ¦ ¦ ¦ ¦ ¦Declared ¦Excess ¦ +----------------+---------+-----------+------------+---------¦ ¦ ¦Year ¦Income tax ¦value excess¦profits ¦ +----------------+---------+-----------+------------+---------¦ ¦ ¦ ¦ ¦ ¦ ¦profits tax ¦tax ¦ +----------------+-+-------+-+---------+------------+---------¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +----------------+-+-------+-+---------+------------+---------¦ ¦ ¦(¦1940 ¦ ¦$1,018.79¦ ¦$461.71 ¦ +----------------+-+-------+-+---------+------------+---------¦ ¦ ¦(¦1941 ¦ ¦18,930.01¦$8,542.55 ¦43,839.87¦ +----------------+-+-------+-+---------+------------+---------¦ ¦Docket No. 15890¦(¦1942 ¦ ¦ ¦3,660.50 ¦40,126.00¦ +----------------+-+-------+-+---------+------------+---------¦ ¦ ¦(¦1943 ¦ ¦ ¦359.03 ¦9,732.54 ¦ +----------------+-+-------+-+---------+------------+---------¦ ¦ ¦(¦1941 ¦ ¦32.04 ¦ ¦ ¦ +----------------+-+-------+-+---------+------------+---------¦ ¦Docket No. 15891¦(¦1943 ¦ ¦21.54 ¦ ¦ ¦ +----------------+-+-------+-+---------+------------+---------¦ ¦ ¦(¦1940 ¦ ¦102.72 ¦26.80 ¦ ¦ +----------------+-+-------+-+---------+------------+---------¦ ¦ ¦(¦1941 ¦ ¦ ¦ ¦512.41 ¦ +----------------+-+-------+-+---------+------------+---------¦ ¦ ¦(¦1942 ¦ ¦963.55 ¦ ¦ ¦ +----------------+-+-------+-+---------+------------+---------¦ ¦Docket No. 15892¦(¦Year ¦)¦ ¦ ¦ ¦ +----------------+-+-------+-+---------+------------+---------¦ ¦ ¦(¦ended ¦)¦961.53 ¦ ¦ ¦ +----------------+-+-------+-+---------+------------+---------¦ ¦ ¦ ¦9-30-43¦)¦ ¦ ¦ ¦ +----------------+-+-------+-+---------+------------+---------¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +-------------------------------------------------------------+

It is admitted that petitioners Leedy-Glover, Inc. (Delaware) and W. B. Leedy & Co. (Delaware) are liable as transferees for any taxes found to be due from their predecessors for the years involved.

The issues are as follows:

(1) Are the commissions on insurance policies written by Leedy-Glover General Agency, Inc., for its principal, on Government owned or operated properties taxable in the year when the policies were issued, or in the years when, under an escrow agreement with the principal, they were released from escrow and paid to, or made payable to, the petitioner?

(2) What was reasonable compensation for the services performed by petitioner's principal officers in the years 1941, 1942, 1943, and 1945?

(3) Did the respondent err in allocating the petitioners' office expenses on the basis of the gross income of each?

(4) Is petitioner W. B. Leedy & Co. entitled to a loss deduction in 1940 on account of the repayment of funds embezzled by one or more of its employees?

As an alternative to issue (1) above, the petitioner, Leedy-Glover Realty & Insurance Co., asks for relief under section 721.

A further issue raised by the pleadings in Docket No. 15890, relating to depreciation deductions on a building, has apparently been abandoned, since no evidence was adduced and no argument made on this issue.

Although no deficiency has been determined for 1945, that year is involved because of the statutory provisions with respect to operating loss and excess profits tax credit carry-back. Several stipulations of fact have been filed, which we adopt as part of our findings.


The taxpayers are corporations, with their principal office located at Birmingham, Alabama. Their returns for the years involved were filed with the collector for the district of Alabama. They kept their books and made their returns on an accrual basis of accounting.

Leedy-Glover General Agency, Inc., hereinafter referred to, sometimes, as the petitioner, was organized January 31, 1935, for the purpose of conducting a general insurance agency. Its organizers were Allen S. Glover and Thomas N. Beach. The capital stock consisted of 20 shares, par value $100 each, 8 of which, during the taxable years involved, were owned by Glover, 1 by Beach, 1 by W. K. Massengill, and 10 by W. B. Leedy & Co. In 1947 its name was changed to ‘Leedy-Glover Realty and Insurance Company, Inc.‘

W. B. Leedy & Co., hereinafter referred to as W. B. Leedy Co., at all times here material conducted a mortgage loan business, with its principal office at Birmingham and branch offices in Mississippi, Florida, Louisiana, Georgia, and Tennessee. Its entire capital stock, except qualifying shares, was owned by Beach. It serviced approximately $50,000,000 mortgage loans during the taxable years involved, and through its business contacts furnished a large portion of the insurance business handled by the petitioner.

Leedy-Glover, Inc., conducted a local insurance agency at Birmingham. It wrote insurance policies through companies represented by the petitioner. Fifty-five per cent of its capital stock was owned by W. B. Leedy & Co., 40 per cent by Glover, and 5 per cent by Massengill. All three of the taxpayer companies occupied offices in the same building in Birmingham and made common use of certain office facilities.

From the date of its organization until 1944, Beach served as petitioner's president and treasurer and Glover as vice president. On January 3, 1944, Glover was elected president and Beach chairman of the board of directors. They were jointly in control of all three of the taxpayer companies during the period involved.

Beach and Glover have been in the insurance business for a number of years and are both recognized as outstanding insurance men in the southeastern states.

About 1937 Beach, Glover, and a third Birmingham insurance man, H. M. Davis, became interested in securing some of the insurance business of the various Federal agencies for southern insurance companies and agencies. They were later joined in this undertaking by E. H. Crump of Memphis, Tennessee, who operated a general insurance agency in that city under the name of E. H. Crump & Co. These individuals made numerous trips to Washington and other places to interview representatives of the various Government departments and agencies. Finally, an agreement was made under which the petitioner and its associates were to procure insurance for certain properties under the administration of Farm Security Administration (FSA). Houston Fire & Casualty Insurance Co. agreed to underwrite such insurance.

On December 15, 1939, Houston Fire & Casualty Insurance Co., hereinafter referred to as Houston, entered into a formal contract with the United States Government through the Secretary of the Department of Agriculture for the insurance of various types of properties, such as dwellings, apartment houses, farm improvements, stores, cotton gins, and others, in which the Federal Government had an interest as owner, mortgagee, or beneficiary under deed of trust. The properties to be insured were located in the various states of the United States, as well as in Puerto Rico and Hawaii. This contract, hereinafter referred to, sometimes, as the Government contract, required Houston to set up and maintain an office in Washington for the purpose of servicing the policies.

On the same date that the Government contract was entered into a separate contract was entered into between Houston, party of the first part, the petitioner, party of the second part, and E. H. Crump & Co., party of the third part, covering the amount of, and the time and method of payment of, the commissions on policies written under the Government contract, and other related matters. It was provided in such contract that for its services petitioner should receive commissions of 17 1/3 per cent of the premiums collected by Houston, plus certain contingent commissions not here involved. Under similar provisions, E. H. Crump & Co. was to receive commissions amounting to one-half of those payable to the petitioner. These stipulated commission rates were revised downward to less than half the original percentages by supplemental agreements entered into in subsequent years. There was a provision in the contract that ‘return commissions‘ on any canceled policies were to be repaid to Houston immediately upon its demand. It was further provided in this contract, as to the payment of the commissions due the petitioner and E. H. Crump & Co. as follows:

* * * that commissions payable on policies issued for a term of one year or less shall be credited to the balances due First Party by the party entitled to such commission; that, on policies written for a term of more than one years, the commission payable to the party shall be divided into as many parts as the number of years for which said policies are written; that, the first part thereof is to be credited to the balances due First Party by the party entitled thereto; and that the remaining part of said commissions due and owing by First Party to the other party shall be deposited in such bank or banking institution as may be designated from time to time, jointly by the First Party and such other party entitled to such commission, under an escrow agreement which shall provide that said bank shall pay unto the said other party entitled thereto each year during the term of any such policies one additional part of said commission, when and as separate premiums on said separate policies are earned, to be paid, however, to said party entitled thereto annually. It is the intent and purpose of the foregoing that the commissions payable to Second and Third Parties, separately and respectively, shall be handed separately under the foregoing separate agreements between First and Second Parties, and First and Third Parties, respectively.

The above provisions for withholding a portion of the petitioner's commissions on policies covering more than one year until the petitioner had performed the services required in connection with the policies was inserted at the insistence of Houston. Most of the policies were for a period of five years.

A separate agreement, such as referred to in the quoted provision of the Houston contract, was entered into by Houston and petitioner on the same date, December 15, 1939, and the National Bank of Commerce in New Orleans Louisiana, was named therein as the depositary bank for the escrowed commissions.

The ‘return premiums‘ mentioned above were to be paid to Houston on demand out of the escrow funds.

The Houston contract further provided that the office which Houston was obligated under the Government contract to establish in Washington would be set up and maintained by petitioner and that the expenses of the office would be borne by petitioner and E. H. Crump & Co. in the proportions, respectively, of two-thirds and one-third each.

There was a contemporaneous oral agreement between the petitioner and H. M. Davis that they would share equally any net profits which petitioner should receive from the Houston contract, as well as any liabilities and losses that the petitioner might incur in carrying out the contract. This agreement was reduced to writing in a contract executed May 31, 1940.

The Government contract differed from the ordinary insurance contract in that it required the insurer to replace the property in the event of loss or damage instead of paying the loss in cash.

The Washington office was set up by the petitioner in accordance with the terms of the contracts. It employed a manager at a salary of from $5,000 to $8,000 per annum and 8 to 20 other employees. Its work consisted of collecting all premiums paid on the Government policies, making settlements on claims, and other services commonly performed by insurance agencies. The total expenses of the Washington office amounted to $14,450.57 for 1940; $29,325.49 for 1941; $44,066.90 for 1942; $37,157.02 for 1943; $46,145.96 for 1944; and $29,203.07 for 1945, to June 30.

The manager of the Washington office was authorized to handle all matters arising in connection with the Government policies. The responsibility of the office rested largely upon Beach and Glover. They were required to make frequent trips to Washington to confer with Government officials on settlement of claims, revisions of the contract, and other matters connected with the business.

The petitioner's commissions on policies written under the Government contract were paid to it in accordance with the provisions of the Houston contract, and the escrow agreement, out of premiums collected on the policies. All of such premiums were first deposited by the petitioner in a Washington bank in an account carried in Houston's name.

Houston and E. H. Crump & Co. entered into a supplemental agreement on December 29, 1939, modifying the Houston contract, which provided that E. H. Crump & Co. might withdraw at the end of each month the entire amount of the commissions payable to it on policies written under the Government contract, whether for one year or longer, as the certificates of insurance were issued. As consideration for this agreement, E. H. Crump personally guaranteed the payment to Houston of the return commissions and other amounts to which it might be entitled under the original Houston contract.

The petitioner reported as income in each year the commissions which were made available to it within the taxable year under the terms of the contracts referred to above. It did not report the commissions which were retained under the escrow agreement. The respondent has determined that the petitioner's entire share of the commissions on all policies written was earned and was accruable in the years when the policies were written, and should have been so reported. Petitioner's share of the gross commissions for each of the taxable years as reported by it in its returns and as adjusted by the respondent was as follows:

+--------------------------------+ ¦ ¦Total gross¦ ¦ +----+-----------+---------------¦ ¦Year¦commissions¦As adjusted by ¦ +----+-----------+---------------¦ ¦ ¦reported ¦respondent ¦ +----+-----------+---------------¦ ¦ ¦ ¦ ¦ +----+-----------+---------------¦ ¦1940¦$11,134.99 ¦$6,849.66 ¦ +----+-----------+---------------¦ ¦1941¦66,901.08 ¦85,946.93 ¦ +----+-----------+---------------¦ ¦1942¦58,417.97 ¦30,576.04 ¦ +----+-----------+---------------¦ ¦1943¦61,693.52 ¦(5,555.64) ¦ +----+-----------+---------------¦ ¦1945¦52,201.12 ¦(29,947.47) ¦ +----+-----------+---------------¦ ¦ ¦ ¦ ¦ +--------------------------------+

The petitioner's gross income for the years 1936 to 1945, inclusive, from all sources, before any adjustments by the respondent, and its net income as shown by its books, before deduction of salaries and bonuses to Beach and Glover and Federal income taxes, were as follows:

+--------------------------+ ¦Year¦Gross ¦Net income¦ +----+----------+----------¦ ¦ ¦income ¦ ¦ +----+----------+----------¦ ¦ ¦ ¦ ¦ +----+----------+----------¦ ¦1936¦$19,560.61¦$4,463.90 ¦ +----+----------+----------¦ ¦1937¦27,515.95 ¦16,761.85 ¦ +----+----------+----------¦ ¦1938¦33,330.26 ¦24,631.04 ¦ +----+----------+----------¦ ¦1939¦30,320.55 ¦20,490.87 ¦ +----+----------+----------¦ ¦1940¦41,175.43 ¦26,121.61 ¦ +----+----------+----------¦ ¦1941¦100,833.04¦64,236.28 ¦ +----+----------+----------¦ ¦1942¦110,188.32¦59,509.53 ¦ +----+----------+----------¦ ¦1943¦104,350.29¦57,945.10 ¦ +----+----------+----------¦ ¦1945¦106,423.21¦55,022.57 ¦ +----+----------+----------¦ ¦ ¦ ¦ ¦ +--------------------------+

The parties have stipulated that the amounts shown above as the commissions under the Houston contract reported by the petitioner, and as adjusted by the respondent, are the correct amounts under their respective contentions with respect to this issue.

The petitioner and its associated companies paid to Beach and Glover salaries and bonuses for the years 1937 to 1945, inclusive, the following amounts, which they deducted in their income tax returns for those years:

+---------------------------------------------------+ ¦Thomas N. Beach ¦ +---------------------------------------------------¦ ¦ ¦Leedy-Glover¦ ¦ ¦ +-------------+------------+-------------+----------¦ ¦Year ¦General ¦Leedy-Glover,¦W.B. Leedy¦ +-------------+------------+-------------+----------¦ ¦ ¦Agency, Inc.¦Inc. ¦& Co. ¦ +-------------+------------+-------------+----------¦ ¦ ¦ ¦ ¦ ¦ +-------------+------------+-------------+----------¦ ¦1937 (9 mos.)¦$6,187.50 ¦ ¦$25,000 ¦ +-------------+------------+-------------+----------¦ ¦1938 ¦8,250.00 ¦ ¦18,000 ¦ +-------------+------------+-------------+----------¦ ¦1939 ¦8,250.00 ¦ ¦18,000 ¦ +-------------+------------+-------------+----------¦ ¦1940 ¦8,250.00 ¦ ¦25,000 ¦ +-------------+------------+-------------+----------¦ ¦1941 ¦17,419.05 ¦$2,750.00 ¦25,000 ¦ +-------------+------------+-------------+----------¦ ¦1942 ¦16,166.71 ¦2,750.00 ¦25,000 ¦ +-------------+------------+-------------+----------¦ ¦1943 ¦15,740.63 ¦2,750.04 ¦25,000 ¦ +-------------+------------+-------------+----------¦ ¦1945 ¦15,418.32 ¦2,750.04 ¦25,000 ¦ +-------------+------------+-------------+----------¦ ¦ ¦ ¦ ¦ ¦ +---------------------------------------------------+

Allen S. Glover 1937 $4,500.00 $6,000.00 1938 6,000.00 6,000.00 1939 6,000.00 6,000.00 1940 6,000.00 6,000.00 1941 15,169.05 8,000.00 1942 13,916.71 8,000.00 1943 13,762.38 8,271.67 1945 13,423.67 8,255.27

For the years 1938, 1939, and 1940 Beach and Glover were paid straight salaries by the petitioner and Leedy-Glover, Inc. Petitioner's board of directors on December 27, 1940, passed a resolution authorizing the payment to each of them, in addition to their regular salaries, a bonus equal to 17 1/2 per cent of net earnings. This arrangement was continued during each of the subsequent taxable years. Of the deductions claimed by the petitioner in its returns, the amounts allowed and the amounts disallowed by the Commissioner were as follows:

+----------------------------------------------+ ¦ ¦Beach ¦Glover ¦ +----+-----------------------------------------¦ ¦Year¦ ¦ +----+-----------------------------------------¦ ¦ ¦Allowed ¦Disallowed¦Allowed ¦Disallowed¦ +----+---------+----------+---------+----------¦ ¦ ¦ ¦ ¦ ¦ ¦ +----+---------+----------+---------+----------¦ ¦1941¦$8,250.00¦$9,169.05 ¦$6,000.00¦$9,169.05 ¦ +----+---------+----------+---------+----------¦ ¦1942¦8,250.00 ¦7,916.71 ¦6,000.00 ¦7,916.71 ¦ +----+---------+----------+---------+----------¦ ¦1943¦8,250.00 ¦7,490.63 ¦6,000.00 ¦7,762.38 ¦ +----+---------+----------+---------+----------¦ ¦1945¦8,250.00 ¦7,168.32 ¦6,000.00 ¦7,423.67 ¦ +----+---------+----------+---------+----------¦ ¦ ¦ ¦ ¦ ¦ ¦ +----------------------------------------------+

The salaries and bonuses paid to Beach and Glover by the petitioner were duly authorized by appropriate corporate action.

Reasonable compensation, including both salaries and bonuses, for the services rendered to petitioner by Beach and Glover in 1941, 1942, 1943, and 1945, is $12,000 per year for Beach and $10,000 per year for Glover.

All three of the taxpayer corporations occupied space in the same office building in Birmingham. They utilized, to some extent, the same office facilities and clerical help and they prorated these expenses on the basis of the estimated amount of services required by each of them. These estimates were made by Beach and Glover on the basis of their personal knowledge of the facilities and services required by each of the companies. The respondent reallocated the expenses on the basis of the gross income of each company. The total expenses of all of the companies for the years 1941, 1942, 1943, and 1945, and the allocations made by them and by the respondent, were as follows:

+-----------------------------------------------------------------------------+ ¦ ¦1941 ¦1942 ¦1943 ¦1945 ¦ +---------------------------------+----------+----------+----------+----------¦ ¦ ¦ ¦ ¦ ¦ ¦ +---------------------------------+----------+----------+----------+----------¦ ¦Paid by W.B. Leedy & Co.: ¦ ¦ ¦ ¦ ¦ +---------------------------------+----------+----------+----------+----------¦ ¦Salaries ¦$8,684.15 ¦$9,815.28 ¦$9,761.91 ¦$12,186.60¦ +---------------------------------+----------+----------+----------+----------¦ ¦Rent ¦3,000.00 ¦3,000.00 ¦3,000.00 ¦3,000.00 ¦ +---------------------------------+----------+----------+----------+----------¦ ¦Lights, heat, ice and water ¦1,363.80 ¦1,404.04 ¦1,394.05 ¦1,423.89 ¦ +---------------------------------+----------+----------+----------+----------¦ ¦Telephone ¦2,461.95 ¦2,315.14 ¦2,403.93 ¦3,824.71 ¦ +---------------------------------+----------+----------+----------+----------¦ ¦Janitor and cleaning expense ¦417.03 ¦405.61 ¦365.48 ¦552.16 ¦ +---------------------------------+----------+----------+----------+----------¦ ¦Depreciation on furniture and ¦1,138.54 ¦1,447.78 ¦1,530.97 ¦1,480.55 ¦ ¦fixtures ¦ ¦ ¦ ¦ ¦ +---------------------------------+----------+----------+----------+----------¦ ¦Total ¦17,065.47 ¦18,387.85 ¦18,456.34 ¦22,467.91 ¦ +---------------------------------+-------------------------------------------¦ ¦ ¦ ¦ +---------------------------------+-------------------------------------------¦ ¦Paid by Leedy-Glover, Inc.: ¦ ¦ ¦ ¦ ¦ +---------------------------------+----------+----------+----------+----------¦ ¦Salaries ¦11,936.46 ¦12,900.36 ¦8,783.78 ¦10,174.62 ¦ +---------------------------------+----------+----------+----------+----------¦ ¦Postage ¦1,917.02 ¦1,876.35 ¦1,648.42 ¦1,809.66 ¦ +---------------------------------+----------+----------+----------+----------¦ ¦Water, heat, lights and power ¦100.66 ¦117.79 ¦92.41 ¦89.78 ¦ +---------------------------------+----------+----------+----------+----------¦ ¦Janitor service and cleaning ¦43.00 ¦25.00 ¦ ¦68.00 ¦ +---------------------------------+----------+----------+----------+----------¦ ¦Depreciation on furniture and ¦198.07 ¦214.19 ¦200.86 ¦170.75 ¦ ¦fixtures ¦ ¦ ¦ ¦ ¦ +---------------------------------+----------+----------+----------+----------¦ ¦Total ¦14,195.21 ¦15,133.69 ¦10,725.47 ¦12,312.81 ¦ +---------------------------------+-------------------------------------------¦ ¦ ¦ ¦ +---------------------------------+-------------------------------------------¦ ¦Total expenses allocable to all ¦$31,260.68¦$33,521.54¦$29,181.81¦$34,780.72¦ ¦companies ¦ ¦ ¦ ¦ ¦ +---------------------------------+-------------------------------------------¦ ¦ ¦ ¦ +---------------------------------+-------------------------------------------¦ ¦Commissioner's allocation: ¦ ¦ ¦ ¦ ¦ +---------------------------------+----------+----------+----------+----------¦ ¦Leedy-Glover General Agency ¦7,294.33 ¦10,637.52 ¦7,129.97 ¦9,348.39 ¦ +---------------------------------+----------+----------+----------+----------¦ ¦Leedy-Glover, Inc. ¦11,735.53 ¦10,683.68 ¦10,025.69 ¦10,846.16 ¦ +---------------------------------+----------+----------+----------+----------¦ ¦W. B. Leedy & Co ¦12,230.82 ¦12,200.34 ¦ ¦14,586.17 ¦ +---------------------------------+----------+----------+----------+----------¦ ¦W. B. Leedy & Co., 9-30-43 ¦ ¦ ¦9,019.61 ¦ ¦ +---------------------------------+----------+----------+----------+----------¦ ¦W. B. Leedy & Co., 12-31-43 ¦ ¦ ¦3,006.54 ¦ ¦ +---------------------------------+----------+----------+----------+----------¦ ¦Total ¦31,260.68 ¦33,521.54 ¦29,181.81 ¦34,780.72 ¦ +---------------------------------+-------------------------------------------¦ ¦ ¦ ¦ +---------------------------------+-------------------------------------------¦ ¦Petitioner's allocation: ¦ ¦ ¦ ¦ ¦ +---------------------------------+----------+----------+----------+----------¦ ¦Leedy-Glover General Agency ¦11,691.48 ¦11,689.10 ¦11,702.87 ¦11,958.64 ¦ +---------------------------------+----------+----------+----------+----------¦ ¦Leedy-Glover, Inc. ¦9,945.50 ¦10,890.35 ¦6,582.03 ¦7,709.41 ¦ +---------------------------------+----------+----------+----------+----------¦ ¦W. B. Leedy & Co ¦9,623.70 ¦10,942.09 ¦ ¦15,112.67 ¦ +---------------------------------+----------+----------+----------+----------¦ ¦W. B. Leedy & Co., 9-30-43 ¦ ¦ ¦8,172.68 ¦ ¦ +---------------------------------+----------+----------+----------+----------¦ ¦W. B. Leedy & Co., 12-31-43 ¦ ¦ ¦2,724.23 ¦ ¦ +---------------------------------+----------+----------+----------+----------¦ ¦Total ¦31,260.68 ¦33,521.54 ¦29,181.81 ¦34,780.72 ¦ +---------------------------------+----------+----------+----------+----------¦ ¦ ¦ ¦ ¦ ¦ ¦ +-----------------------------------------------------------------------------+

Included in the amounts allocated to the petitioner was the payment which it made to Leedy-Glover, Inc., of $7,200 each year for services rendered by employees of that company and additional amounts of $2,675 in 1941, $3,900 in 1942, $3,900 in 1943, and $4,180 in 1945, for the use of facilities. The petitioner also made a payment to W. B. Leedy Co. in 1941 of $1,000 for the use of that company's facilities. The other lesser amounts making up the totals, as shown above, were for items not here in controversy.

The petitioner's payments to Leedy-Glover, Inc., in 1941 and subsequent years were substantially greater than those for the prior years 1938, 1939, and 1940. The petitioner required more floor space and more clerical help in the latter years.

No account was kept in the records of any of the companies of the actual cost of the services which each received and there are no records from which such figures might be obtained.

In connection with its real estate operations, W. B. Leedy Co. acted as rental agent for numerous property owners. It collected rents from the tenants, which it deposited in its own bank account, and it periodically sent the landowners their portion of the rent moneys, after deducting its commissions. In April 1940 officials of the company discovered that there was a shortage of $2,627 in its rents collections. The company made good the shortage by paying the landowners, in that year, the full amounts due them. Recovery was later made of $108 of missing funds. The employee or employees who were responsible for the shortage were financially unable to make restitution of any of the balance. In its return for 1940, Leedy-Glover, Inc., claimed the amount of $2,519 as a deductible loss resulting from embezzlement. The respondent disallowed $1,029 of the amount so claimed on the ground that that portion of the loss was sustained in 1939.


LE MIRE, Judge:

(1) Accrual of commissions.— Respondent's position on this issue is that the petitioner, making its return on an accrual basis, should have accrued as income in each of the taxable years the entire amount of the commissions on insurance which it wrote for Houston in that year under the Government contract. The petitioner contends that it correctly reported only the commissions which, under its agreement with Houston, were payable to it within the taxable year, excluding the commissions held under the escrow agreement.

Under the Government contract, Houston was to receive the standard premiums for the state or territory in which the property was located on each policy issued, not to exceed 40 cents for each $100 of insurance. The premiums were due and payable when the policies were issued. Under its contract with Houston, the petitioner was entitled to commissions of 17 1/3 per cent of the entire premiums on each policy issued. However, under further provisions of the Houston contract and the escrow agreement, petitioner was not entitled to receive its full commission when the policies were issued if the policy was for more than one year, but was entitled to receive in the first year the proportional part of the commissions allocable to that year. The balance of the commissions was placed in the escrow bank, subject to withdrawal only as authorized by joint statement submitted by Houston and petitioner showing their respective interests in the fund. The commissions to which the petitioner became so entitled were credited to it monthly over the terms of the policies. Any portions of the premiums returnable on canceled policies were charged against the petitioner and credited to Houston.

The petitioner's right to commissions must be determined under its contract with Houston rather than under Houston's contract with the Government. The fact that under the Government contract Houston's entire share of the premiums was due and payable when the policies were issued does not affect petitioner's right as agent for Houston. The petitioner and Houston were free to arrange their contract as they saw fit.

Actually, the Houston contract required the petitioner to maintain a Washington office at considerable expense and to service the policies which it wrote over their full terms. The purpose of the escrow provision was to protect Houston against possible loss of the return commissions on canceled policies and to place the cost and responsibility of serving the policies on the petitioner. The evidence is that ‘thousands‘ of the policies were canceled. The agreement for placing the commissions in escrow was not, as the respondent in his brief suggests, a voluntary arrangement on petitioner's part for postponing its receipt of the commissions and deferring its tax liability thereon until a subsequent year. This provision was put into the contract at the insistence of Houston and for its protection.

Ordinarily, income is accruable when the right to receive it becomes fixed. Spring City Foundry Co. v. Commissioner, 292 U.S. 182. In North American Oil Consolidated v. Burnet, 286 U.S. 417, the Supreme Court held that impounded founds were income to the taxpayer ‘when it first became entitled to them and when it actually received them,‘ whether it made its returns on a cash basis or on an accrual basis.

Advance payments held by a landlord as security for the performance of the conditions of the lease have been held not taxable income until the happening of some event which gives the landlord the present, unrestricted right of ownership of the funds. See Clinton Hotel Realty Corporation v. Commissioner, 128 Fed.(2d) 968, and Warren Service Corporation v. Commissioner, 100 Fed.(2d) 723.

The respondent argues in his brief that under the several contracts the petitioner's commissions were all ‘earned, due, owing, and payable in the year when the policies were written.‘ The facts are, however, that the commissions were not fully earned, because of petitioner's obligation to service the policies over their full terms, and they were not wholly due, owing, or payable to petitioner until it had performed those services. Moreover, it is not the time of earning income that determines the time of its accrual. For instance, compensation for personal services paid in advance of the services is taxable in the year of its receipt. Your Health Club, Inc., 4 T.C. 385. So are advance rentals if paid without restriction as to the landlord's use and ownership of them. United States v. Boston & Providence R. Corporation, 37 Fed.(2d) 670; Renwick v. United States, 87 Fed.(2d) 123; Commissioner v. Lyon, 97 Fed.(2d) 70.

The petitioner cites Brown v. Helvering, 291 U.S. 193. The Supreme Court held in that case that the overriding commissions received by a general agency for fire insurance companies on policies written by its local agents were taxable in their entirety in the year of their receipt, without any reduction on account of contingent liability for return premiums on canceled policies. The Court said:

The overriding commissions were gross income of the year in which they were receivable. As to each such commission there arose the obligation— a contingent liability— to return a proportionate part in case of cancellation. But the mere fact that some portion of it might have to be refunded in some future year in the event of cancellation or reinsurance did not affect its quality as income. Compare American National Co. v. United States, 274 U.S. 99. When received, the general agent's right to it was absolute. It was under no restriction, contractual or otherwise, as to its disposition, use, or enjoyment. Compare North American Oil Consolidated v. Burnet, 286 U.S. 417, 424. * * *.

In further ruling that the overriding commissions could not be allocated to future years extending over the life of the policies, the Court pointed out (1) that the Board of Tax Appeals had concluded that there was no proof that the overriding commissions contained any element of compensation for services to be rendered in future years; (2) that the full amount of the overriding commissions had at all times been treated by the taxpayer and the Commissioner as income in the year in which the policies were written; and (3) that the Commissioner, in the exercising of his wide discretion, was of the opinion that the method of accounting maintained by the taxpayer in prior years, when no account was set up and no deductions claimed for the contingent liability for return commissions, accurately reflected the taxpayer's income.

The reasons given by the Court for its ruling in that case clearly point the factual differences which distinguish it from the instant case. Here, there is uncontradicted evidence that the commissions payable to petitioner were in part consideration for services to be performed in the future; the petitioner has not at any time treated the full amount of the commissions as income in the years when the policies were written; and petitioner's deferment of the accrual of portions of the commissions to the years extending over the terms of the policies did not result from any change in its established method of accounting.

Of even more importance, we think, is the fact that here, contrary to the situation in the Brown case, supra, the full commissions were not received by the petitioner in the years when the policies were written and were not subject to petitioner's unrestricted use and enjoyment.

In San Francisco Stevedoring Co., 8 T.C. 222, we said that ‘Income does not accrue to a taxpayer using an accrual method until there arises in him a fixed or unconditional right to receive it.‘

We think that the respondent was in error in including in petitioner's income the commissions which it had not received and to which, under its contract with Houston, it had not fixed right at the close of the year.

(2) Officers' compensation.— The salaries and bonuses paid to Beach and Glover by the petitioner in 1941, 1942, 1943, and 1945 are involved in this issue. Beach was an officer of, and drew salaries, and in some years bonuses, from all three of the taxpayer companies. Glover had no interest in W. B. Leedy Co., but was an officer of, and drew compensation from, the petitioner and from Leedy-Glover, Inc. The amounts of such salaries and bonuses paid to, and claimed as deductions by, the petitioner and the adjustments made by the respondent are shown above, with such other facts pertaining to the question of the reasonableness of such compensation for the services performed as the evidence contains. The evidence, in our opinion, fails to justify the full amounts claimed by petitioner, but, on the other hand, it indicates that the amounts allowed by the respondent are somewhat less than reasonable compensation for the services performed by the officers. We have concluded, and have so found above, that reasonable compensation for the services performed for the petitioner by these officers for each of the years involved is $12,000 for Beach and $10,000 for Glover. The amounts so determined represent our best judgment, based on all the factors disclosed by the evidence, as to the compensation properly allowable to each of the officers for the years involved.

(3) Allocation of expenses.— All three of the taxpayer companies occupied offices in the same building and made common use of certain office facilities and clerical help. They apportioned, or allocated, expenses for 1941, 1942, and 1943 among themselves on the basis of the amount of the services and benefits received by each of them. The respondent made a reallocation of the expenses among the companies under section 45, Internal Revenue Code. He based his allocation on the gross income of each of the companies.

Section 45 of the code authorizes the Commissioner to make such allocation only where two or more organizations are owned or controlled by the same interests and where he determines that ‘such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses.‘ The Commissioner is given broad discretionary powers in the application of this provision of the statute and his determination can be set aside only if shown to be arbitrary and unreasonable. The burden is upon the taxpayer to prove it so. Welworth Realty Co., 40 B.T.A. 97; Seminole Flavor Co., 4 T.C. 1215. The adjustments which the respondent has made with respect to each of the companies are set out above. In each year the amount claimed by the petitioner was reduced, and the amounts claimed by the other two companies were increased accordingly. The amounts claimed by the petitioner were reduced from $11,691.48 to $7,294.33 in 1941; from $11,689.10 to $10,637.52 in 1942; and from $11,702.87 to $7,129.97 in 1943. The evidence is that the petitioner used more office space and required more services than either of the other companies. The Commissioner's allocation so recognizes, for each year the amount allocated to the petitioner is approximately twice that allocated to the other two companies combined. Although the method of allocation used by the respondent, based on the gross income of each company, might appear to be arbitrary, we can not say, on any evidence before us, that it led to arbitrary and unreasonable results. Our concern is more with the ultimate results arrived at by the Commissioner than the methods which he uses. Exact records of the costs of the operations of each of the companies might have shown a result different from that reached by the respondent, but, admittedly, no such records were kept and could not now be established. Thus, the petitioner is itself responsible for the absence of proof upon which the respondent's determination might be challenged.

SEC. 45. ALLOCATION OF INCOME AND DEDUCTIONS.In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Commissioner is authorized to distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses.

On the evidence before us, the respondent's determination must be sustained.

(4) Embezzlement losses.— The petitioner, W. B. Leedy & Co., claimed the deduction in 1940 of $2,519 as a loss due to the embezzlement of funds by one or more of its employees. The funds in question were rentals which it had collected as agent for the landlords. The petitioner discovered the shortage in April 1940 and restored the funds in April or May of that year. The respondent disallowed $1,029 of the $2,519 claimed on the ground that that portion of the loss was sustained in 1939 and should have been deducted in that year instead of 1940 when the loss was discovered.

The petitioner contends here that the misappropriated funds were not its own, but were the property of the landlords, and that it sustained no loss until it recognized its liability for the amount of the embezzlement and reimbursed the owners for their loss.

The respondent relies upon the general rule that embezzlement losses must be deducted in the year when the embezzlement occurs, but see Boston Consol. Gas Co. v. Commissioner, 128 Fed.(2d) 473, and Gwinn Bros. & Co., 7 T.C. 320. However, we think the petitioner is correct in its contention that the embezzled funds were not its property, but belonged to the landlords for whom it had been collected, and that petitioner sustained its loss when it restored the funds in 1940. John H. Farish & Co. v. Commissioner, 31 Fed.(2d) 79. See also Israel T. Deyo, 9 B.T.A. 900, and Peter Frees, Jr., 12 B.T.A. 737.

Decisions will be entered under Rule 50.